The Determinants of Professional Fees in Large Bankruptcy Reorganization Cases

Transcription

1 Journal of Empirical Legal Studies Volume 1, Issue 1, , March 2004 The Determinants of Professional Fees in Large Bankruptcy Reorganization Cases Lynn M. LoPucki and Joseph W. Doherty* This article reports on one of the most extensive studies to date of the professional fees and expenses awarded by U.S. bankruptcy courts in the reorganizations of large, public companies. Over the past three decades, scholars have made numerous attempts to estimate the amounts of professional fees and expenses awarded by U.S. bankruptcy courts in the reorganizations of large, public companies. 1 They faced major barriers to data gathering. As a practical matter, the only reliable source of data on the fees in a given case is the judge s order approving payment, and the only practical means for obtaining the data has been to travel to the court 2 and examine the case *LoPucki is the Security Pacific Bank Professor of Law at the UCLA School of Law; Doherty is the Associate Director of the UCLA School of Law s Empirical Research Group. Address correspondence to Lynn M. LoPucki, lopucki@law.ucla.edu. Both the data and the statistical runs from this study are posted on the website of the UCLA Law School Empirical Research Group, We thank Brian Betker, Tim Fisher, Bob Lawless, Steve Lubben, Jocelyn Martel, and Bob Rasmussen for comments on earlier versions of the manuscript, the Council on Research of the UCLA Academic Senate and the UCLA School of Law for the financial support that made this study possible, and Chris Wichrowski for the major role she played in assembling data as the principal research assistant on the project. 1 Karen Hopper Wruck, Financial Distress, Reorganization, and Organizational Efficiency, 27 J. Fin. Econ. 419, (1990) (compiling a variety of estimates of direct and indirect costs of bankruptcy). 2 James S. Ang, Jess H. Chua & John J. McConnell, The Administrative Costs of Corporate Bankruptcy: A Note, 37 J. Fin. 219, 220 (1982) (examining only cases from the Western District of Oklahoma); Michelle J. White, Bankruptcy Costs and the New Bankruptcy Code, 38 J. Fin. 477, 483 (1983) (examining only cases from the Southern District of New York). 111

2 112 Professional Fees in Bankruptcy Reorganization file. 3 As a result, sample sizes have been small. 4 Researchers typically have reported professional fees as fixed percentages of some dollar measure of firm size, ranging from a low of 1 percent to a high of 6 percent. 5 During the 1990s, the bankruptcy courts began making their dockets available on the Internet through PACER. Toward the end of that decade, they began posting the full text of at least some of the documents contained in the court files. It is not yet possible to acquire all the fee applications and orders in a given set of cases through PACER, so one cannot yet compile the documents for a random national sample. 6 However, it is both possible and practical to acquire nearly all the fee applications and orders in a substantial proportion of a given set of cases. That is what we did. Earlier researchers who attempted to study large, public company bankruptcies also faced two additional problems: identifying the universe of cases and gathering data on the numerous variables that might be tested. No lists of large, public company bankruptcies were published or available through the courts. 7 As a result, researchers interested in large reorganiza- 3 Copies of court documents can be ordered directly from the courts, but the process is expensive and nightmarishly difficult. It often ends only in the discovery that the documents have been archived. Inserting a document retrieval company between the research and the court reduces the hassle, but drives the expenses above what most researchers can pay. See generally Lynn M. LoPucki, The Politics of Research Access to Federal Court Data, 80 Tex. L. Rev (2002). 4 E.g., Jerold B. Warner, Bankruptcy Costs: Some Evidence, 32 J. Fin. 337, 340 (1977) (11 railroad sample); Edward I. Altman, A Further Empirical Investigation of the Bankruptcy Cost Question, 39 J. Fin. 1067, 1073 (1984) (sample of 12 retailers and seven other industrial firms); Stephen J. Lubben, The Direct Costs of Corporate Reorganization: An Empirical Examination of Professional Fees in Large Chapter 11 Cases, 74 Am. Bankr. L.J. 509 (2000) (sample of 22 cases). 5 E.g., Warner, supra note 4, at 337 ( cost of bankruptcy 1 percent of market value of the firm prior to bankruptcy); Altman, supra note 4, at ( direct bankruptcy costs 6 percent of the market capitalization of the firm); Lubben, supra note 4, at 538 ( The present study reports the director costs of bankruptcy at 1.82% of assets. ). 6 See LoPucki, supra note 3, at (2002) (discussing restrictions on usability for research deliberately built into the PACER system). 7 Since the early 1980s, the SEC has maintained a list of large, public company bankruptcies that researchers can obtain by Freedom of Information Act Request. E.g., Securities Exchange Commission, Public Company List: SEC Appearance Filed October 1, 1996 through September 30, 1997 (on file with Lynn M. LoPucki).

3 LoPucki and Doherty 113 tions had to rely on newspaper searches or stock trading data to select a set of cases for study and then explore a variety of sources for data on those cases. 8 To address this problem, one of us compiles, and makes available on the Internet, basic data on all bankruptcy cases filed by large, public companies, together with a search engine that will compile subuniverses based on a variety of criteria. Data on 618 cases filed from 1980 through April 2003 are now available. 9 With these advantages, we were able to compile almost complete data on the amounts of fees and expenses applied for and awarded to professionals in 48 recently concluded large, public company reorganizations. Based on analysis of this larger sample of more representative cases we constructed a regression model of the principal determinants of fees and expenses. The most important findings are the following. 1. Four factors determined the amounts of fees and expenses. In declining order of importance, they are firm size (measured by assets reported on the petition), time elapsed from filing to plan confirmation, the number of professional firms authorized to incur fees, and whether the case proceeded in the Delaware Bankruptcy Court. 2. The ratio of fees to assets is subject to a scale effect. As the size of the case increases, the ratio of fees to expenses declines. 3. The total fees and expenses in the 48 cases studied were 1.4 percent of the debtors total assets as reported in the bankruptcy files at the beginning of their bankruptcy cases. The average ratio of the fees and expenses paid by a company to total assets of the company was 2.2 percent; however, removal of a single outlier reduced it to 1.9 percent. 4. Controlling for firm size, case duration, and the number of professional firms working, fees were 32 percent higher in Delaware cases. Controlling only for firm size, the difference was not significant. 8 E.g., Michael Bradley & Michael Rosenzweig, The Untenable Case for Chapter 11, 101 Yale L.J. 1043, 1059 (1992) (using the Wall Street Journal Index to compile a list of bankrupt firms listed on the New York and American stock exchanges). 9 Lynn M. LoPucki, Bankruptcy Research Database (WebBRD edition 2003), available at

4 114 Professional Fees in Bankruptcy Reorganization 5. Whether the firm was solvent was not a significant determinant of the amount of fees incurred, but the ratio of assets to liabilities was, weakly, such a determinant. 6. Courts awarded nearly all the fees and expenses professionals sought. Reductions in the amounts awarded from the amounts sought exceeded 4 percent of the amounts sought in only 11 percent of the cases. The mean fee and expense cut varied significantly by court. Delaware cuts averaged 0.7 percent, New York 4.5 percent, and other courts 2.3 percent. Fees and expenses were not significantly lower in cases with larger cuts. 7. Firm size and case duration were the principal determinants of the amount of fees debtors in possession paid their bankruptcy attorneys. Neither the number of professional firms employed in the case nor the location of the case in Delaware appeared to affect the amounts of these fees. 8. Eighty percent of the $560 million of fees paid in these 48 cases were paid for representation of the debtor in possession. Under 1 percent of the fees were paid for the representation of equity holders. (Funds were expended on the representation of equity in only two cases.) The remainder was paid almost entirely for the representation of creditors. 9. The inflation-adjusted professional fees and expenses awarded in a public company reorganization of a given size have fallen by about 57 percent since the 1980s. Controlling only for firm size, the difference is statistically significant. The decline in fees appears to be associated with the decline in case duration that occurred since that period. The regression model we developed also has an important practical application. The model provides the most accurate method available for estimating the professional fees and expenses a firm will pay if it files bankruptcy and for evaluating comparatively the fees and expenses awarded in a case that has been concluded. To facilitate this use, we developed a computer program, the Bankruptcy Fee Calculator, that uses our regression formulae to predict awarded fees and expenses from the user s estimate of asset size. To refine the estimate, the user can also enter case duration, number of professional firms, and/or case location The Bankruptcy Fee Calculator is posted at

5 LoPucki and Doherty 115 Part I of this article describes our study methods. Part II describes the regression model that explains the aggregate amounts of fees and expenses awarded all professionals. Part III describes the regression model that explains the aggregate amounts of fees and expenses awarded to bankruptcy attorneys employed directly by the debtor in possession. Part IV compares the aggregate fees and expenses awarded in the cases we studied with the aggregate fees and expenses awarded in a set of early 1980s cases studied by Professor Lawrence Weiss. In Part V, we report our conclusions as to the implications of our findings. I. THE STUDY This article reports on a study of professional fees and expenses awarded by U.S. bankruptcy courts in the Chapter 11 cases of 48 large, public companies whose plans were confirmed in the period from 1998 through mid The 48 cases studied are approximately 30 percent of the 158 cases that resulted in confirmation of a plan that reorganized or liquidated a large, public company during that period. The sample is not random; it is a sample of convenience. In general, the firms chosen were those for which we could most easily gather data. We also made an effort to include cases from courts other than Delaware and New York, even though fee information was more readily available for Delaware and New York cases. Firms were identified from Lynn M. LoPucki s Bankruptcy Research Database (BRD). 11 The BRD includes data on all large, 12 public 13 companies filing bankruptcy cases in the United States during the period covered by the study. 11 Three cases not currently included in the BRD were included in this study because they were included in the BRD at the time we selected our sample. The three cases were Unison Healthcare, Greate Bay Hotel, and Stratosphere Corp. In each of those cases, the debtor s petition reported assets in an amount sufficient to qualify for inclusion in the BRD, but the debtor s Form 10-K reported a lesser amount. BRD protocols were revised to consider only assets as reported on Form 10-K. 12 For purposes of inclusion in the BRD, a company is considered large if it reported assets in excess of $100 million, measured in 1980 dollars, on the last Form 10-K it filed with the SEC for a period ended prior to bankruptcy. That amount is approximately $218 million in 2002 dollars. 13 Firms are considered public if they filed a Form 10-K with the SEC for a fiscal year ended not more than three years prior to the filing of the bankruptcy petition.

6 116 Professional Fees in Bankruptcy Reorganization We obtained most of our data directly from the court files, using PACER. 14 We collected the fee applications (minus attachments) and orders either directly from the court file or, in a few cases, from document retrieval firms. In other cases, we were able to obtain the necessary information from the dockets, without consulting the applications and orders. 15 The total number of applications discovered and analyzed was 522. Bankruptcy Code 330(a)(1) authorizes the court to award to a... professional person [whose employment was previous authorized by the court] reasonable compensation for actual, necessary services rendered... and... reimbursement for actual, necessary expenses. Bankruptcy Rule 2016 requires that: An entity seeking interim or final compensation for services, or reimbursement of necessary expenses from the estate shall file an application setting forth a detailed statement of (1) the services rendered, time expended and expenses incurred, and (2) the amounts requested. An application for compensation shall include a statement as to what payments have therefore been made or promised to the applicant for services rendered or to be rendered in any capacity whatsoever in connection with the case The law allows estates to pay only compensation approved by the court on such an application. 17 Thus the court files should contain complete information on the amounts of compensation applied for and paid from the debtor s estate for professional fees and expenses in connection with the [bankruptcy] case PACER is an acronym for Public Access to Court Electronic Records. The system is available at 15 The courts involved did not post the applications and orders on PACER, but did include in the docket entries the amounts of fees and expenses applied for and awarded U.S.C E.g., 1 Robert E. Ginsberg & Robert D. Martin, Bankruptcy 4.05[A][1] (4th ed. 2003) ( A professional for the trustee who wants to be compensated from the estate must go to the bankruptcy court for that compensation. ). 18 See text accompanying note 16.

7 LoPucki and Doherty 117 Commentators have generally considered these fees and expenses to be the direct costs of bankruptcy. 19 However, several problems with this equation are worthy of note. First, this measure includes only professional fees and expenses advanced by the professionals. Debtors may incur and pay other kinds of expenses directly resulting from the bankruptcy filing that might not make their way onto these applications. For example, the debtor might pay directly the court s filing fees or the travel expenses of the firm s executives to attend court. Second, professionals who work on behalf of secured creditors may be entitled to recover their fees and expenses as part of their clients secured claims. 20 Technically, these amounts are not paid from the debtor s estate. They are paid from the secured creditors collateral. However, their payment directly reduces the value of the estate, so the effect is exactly the same as if they were paid from the estate. Nevertheless, these amounts are not included in Rule 2016 applications, have not traditionally been included in studies of professional fees, and are not included in this study. 21 Third, the phrases professional fees 22 and in connection with the [bankruptcy] case 23 are both ambiguous and may be interpreted differently in different local legal cultures. 24 As an example of the first ambiguity, a real estate broker who sells property of the estate may or may not be considered a professional who must file a fee application. As an example of the second, fees incurred prepetition for the negotiation, preparation, and approval by 19 Some researchers have treated them as the equivalent of expenses of administration. They are not. Expenses of administration is a broader category that includes professional fees along with other expenses of operation or liquidation. 11 U.S.C. 503(b) U.S.C. 506(b). 21 The records of the bankruptcy courts probably provide insufficient information for their inclusion on any systematic basis U.S.C. 327(a) ( the trustee, with the court s approval, may employ one or more attorneys, accountants, appraisers, auctioneers, or other professional persons... ). 23 See text accompanying note Although the Bankruptcy Code and Rules apply in all districts, large differences exist in practices and outcomes. The causes of these differences are lumped together in the concept of local legal culture. Teresa A. Sullivan, Elizabeth Warren & Jay Lawrence Westbrook, The Persistence of Local Legal Culture: Twenty Years of Experience from the Federal Bankruptcy Courts, 17 Harv. J.L. & Pub. Pol y 801 (1994).

8 118 Professional Fees in Bankruptcy Reorganization creditors of a prepackaged plan of reorganization may or may not be considered to have been incurred in connection with the case. 25 Fourth, courts generally require that professionals file final fee applications shortly after confirmation of the reorganization plan. Those applications cover the period through confirmation, but may also include some post-confirmation fees. 26 As a result, some post-confirmation fees are included in our data, and the extent to which that occurred differed a little from case to case. We collected our data once the final applications and orders were in the court file. In some cases, some of the professionals continued to incur fees in connection with the case. We did not include the later fees in our study. 27 Fifth, professional fee and expense awards include only the professional fees and expenses the debtor s estate will pay. These amounts frequently include fees incurred for the representation of creditors committees, equity committees, indenture trustees, and others. However, professional fees and expenses awarded do not include professional fees and expenses paid by parties other than the debtor in possession without reimbursement from the estate. That results in the omission from a study such as ours of fees paid in connection with the bankruptcy case by individual creditors, lessors to the debtor, lessees from the debtor, parties to executory U.S.C Our study included only three prepackaged cases: Farm Fresh (Delaware), Cityscape Financial (White Plains), and Grand Union 1998 (Newark). The debtor must have incurred professional fees and expenses in all three to propose and obtain acceptance of a plan of reorganization prior to the filing of the bankruptcy case. Consistent with this supposition, the debtor in possession s (DIP s) financial advisor in Farm Fresh sought compensation and reimbursement for a period commencing more than a year prior to the bankruptcy filing. Inconsistent with this supposition, the principal fee applications in the other two prepackaged cases covered only periods commencing approximately at the filing of the petition. The professional firms that assisted Cityscape Financial, Grand Union, and their creditors in negotiating and winning acceptance of the plan must have concluded that their prepetition work was not in connection with the bankruptcy case. 26 Each fee application specified the dates covered. We collected these dates and included them in the data available at In a few cases, the dates ended prior to entry of the confirmation order (but presumably after the confirmation hearing). In most the dates ended on the date of entry of the confirmation order or within two or three weeks thereafter. Rarely did the dates end more than four months after confirmation. 27 To include all fees awarded by the court in connection with the case might have required that we continue to follow the cases for several years before reporting. The amounts of additional fees incurred probably would have been small in comparison with the fees incurred through confirmation.

9 LoPucki and Doherty 119 contracts with the debtor, suppliers, utilities, and others who are not eligible for reimbursement. These five factors each tend to cause our calculation of professional fees and costs to understate the direct costs of bankruptcy. 28 One other factor causes a tendency in the opposite direction. As with all studies of the direct costs of bankruptcy, 29 some portion of the fees applied for and awarded by the court in our cases would have been incurred even in the absence of a bankruptcy case. One example is the fees of special counsel retained by the estate to litigate disputes that would have been litigated in the absence of bankruptcy. Another example is the fees of financial advisors in connection with sales of assets that would have been sold even in the absence of bankruptcy. Because of these difficulties in measurement, the amounts of professional fees and expenses reported in this and other similar studies should not be considered equivalent to the direct costs a firm must pay for the advantages of bankruptcy. The latter could be either higher or lower than the former. With the exception of prepackaged cases, however, the fee award process appeared sufficiently uniform to support intercase comparisons. We focus on those comparisons. II. THE PROFESSIONAL FEES AND EXPENSES REGRESSION MODEL Because we selected our sample of cases from the BRD, we had ready access to data on a variety of firm and case characteristics. These data enabled us to test a larger number of relationships than have earlier researchers. The variables we tested for in our model included the size of the firm (using eight different standards of measurement), the length of the case, the court, the number of professional firms working, whether the firm was solvent, the type of plan (prepackaged, prenegotiated, or neither), the firm s industry, 28 Lubben raises a sixth possibility: fees that are incurred and paid by the estate without the required application and authorization. Lubben, supra note 4, at 538. The cases we studied were much larger than those Lubben studied. We doubt that the debtors in our sample each with assets in excess of $200 million paid significant amounts without authorization. 29 Lubben, supra note 4, at 519 ( In short, all studies of the direct costs of Chapter 11, including the present one, by design overstate the costs of Chapter 11 through inclusion of professional fees that would be incurred regardless of the Chapter 11 filing. ).

10 120 Professional Fees in Bankruptcy Reorganization the amounts of fee cuts, whether the firm was liquidated during the bankruptcy case, whether the debtor s lawyers were from New York, whether the firm reorganized or liquidated, and whether the debtor s lawyers were local to the court. We selected variables for inclusion in the model based on three criteria. First, the bivariate relationship between each variable and professional fees and expenses had to be significant, as determined using Pearson s R correlation. Second, the variables could not be confounded with each other. In those cases where variables were confounded, we selected for our model the one with the strongest correlation to fees. 30 Third, the addition of the variable to the equation had to significantly improve the R 2, or fit, of the model. From this procedure we settled on four variables: assets reported on the petition, case duration, the number of professional firms seeking fees, and location (whether the case was in Delaware). A. The Basic Model We used ordinary least squares regression (OLS) to estimate the parameters of the model. The model indicates that the size of the firm and the length of time a case remains pending are the strongest determinants of professional fees awarded. The third variable the number of professional firms authorized to work in the case is also significant but had less absolute influence on fees and expenses. 31 A model that considers only these three factors explains 77 percent of the variance of fees. 32 Controlling for those three factors, fees were significantly higher if the case was filed in Delaware, so we added court location to the model We made one minor exception by choosing petition value of assets over the average of petition value of assets and petition amount of liabilities as the measure of firm size. The latter value had a very slightly stronger correlation to fees, but we chose the former because it will be easier for users of the model to obtain. See infra Part II.A The standardized coefficients (betas) for firm size and days in bankruptcy are nearly identical: and The beta for the number of firms is 0.311, which suggests that the relative importance of that variable is less than the other two. 32 To prevent the cases with the highest absolute values from dominating the model, we used the logarithm of the values for fees awarded, number of firms working, and days in bankruptcy. This decision was validated using the Kolmogorov-Smirnov test for normal distribution. 33 p = 0.04.

11 LoPucki and Doherty 121 Table 1: Correlates of Professional Fees and Expenses Awarded in Large Chapter 11 Bankruptcy Cases, I II Assets 0.414** 0.367** natural log, mean = 6.17, sd = Days in bankruptcy 0.535** 0.565** natural log, mean = 5.67, sd = Number of professional firms 0.063** 0.065** mean = 10.85, sd = Delaware 0.321* mean = Constant 9.486** 9.458** Adjusted R N *p < 0.05; **p < NOTE: Dependent variable = natural log of total fees and expenditures (OLS coefficients, standard errors in italics). Since the dependent variable is a natural logarithm we can interpret these regression coefficients as elasticities, that is, as the percentage change in the awarded fees and expenses given a one-unit change in the independent variable, all else held constant. For example, the regression model indicates that fees and expenses are, on average, 32 percent higher in Delaware than in other courts, when we hold constant assets, number of firms, and days in bankruptcy. Similarly, fees and expenses increase by 6.5 percent with each additional professional firm, holding the other factors constant. The coefficients for assets and days in bankruptcy have a slightly different interpretation, as both the dependent and the independent variables are logarithms. The coefficients are interpreted as the percentage change in the dependent variable when the independent variable changes by 1 percent. For example, a 1 percent change in assets results in a percent change in fees; and a 1 percent change in the number of days results in a percent change in fees, when all else is held constant. These are known as log-log regressions, and they reveal an interesting fact about the relationship of fees, assets, and days in bankruptcy. As assets and days increase, so do fees, but at a declining rate. The implications of these findings will be discussed in more detail in the sections that follow.

12 122 Professional Fees in Bankruptcy Reorganization 1. Firm Size In examining professional fees, researchers have measured the size of the firm in a variety of ways. They have used (1) the book value of assets, measured at the fiscal year-end prior to the bankruptcy filing, 34 (2) the value of assets reported by the debtor on the bankruptcy petition, 35 (3) the book value of debt plus the market value of equity, 36 (4) the market value of public debt plus the book value of other debt plus the market value of equity, 37 (5) the market value of debt plus the market value of equity, 38 (6) the market value of equity, 39 (7) the amount of debt as reported on the bankruptcy petition, 40 (8) the sum (or average) of the value of assets and debts reported on the petition, 41 (9) the liquidated value of the firm at the end of the bank- 34 Lawrence A. Weiss, Bankruptcy Resolution: Direct Costs and Violation of Priority Claims, 27 J. Fin. Econ. 285, 289 (1990) (using book value of total assets...measured at the fiscal year end prior to the bankruptcy filing as one of three measures for reporting); Elizabeth Tashjian, Ronald C. Lease & John J. McConnell, Prepacks: An Empirical Analysis of Prepackaged Bankruptcies, 40 J. Fin. Econ. 135, 144, 156 (1996). 35 Lubben, supra note 4, at (suggesting that Lubben used assets as reported to the bankruptcy court at the time of the bankruptcy case as the measure of firm size). 36 Weiss, supra note 34, at 289 ( book value of debt plus the market value of equity ). Weiss does not report the source of the values he used. In our attempt to replicate it, we used the amount reported on the debtors schedules as the measure of debt, Compustat data item 130 (Preferred Liquidating Value) as the value of preferred stock, and the CRSP common share price multiplied by the CRSP shares outstanding as the value of the common stock. We know of no practical source for the trading values of preferred stock or the market values of common stock issues other than the one reported for each firm in CRSP. 37 Altman, supra note 4, at 1076 ( The total value of the firm was measured by adding the market value of equity (preferred and common) to the market value of debt (where available) plus the book value of other debt plus the capitalized value of financial leases. ). 38 Warner, supra note 4, at 337 (reporting the cost of bankruptcy as about one percent of the market value of the firm prior to bankruptcy ). 39 Weiss, supra note 34, at 289 ( the market value of equity ). 40 Lubben, supra note 4, at (use of petition values); id. at (adding assets to liabilities to get total firm size ). 41 Id.

13 LoPucki and Doherty 123 ruptcy process, 42 and (10) the distributions to creditors made during the case by stay lifting, asset abandonment, or payments under the plan. 43 One might also measure firm size by (11) the dollar amount of revenues or (12) the number of employees. The use of so many different measures of size caused two problems in the literature. First, the results of studies are not comparable, so they can neither be compiled into meta-studies, nor used to compare changes over time or among types of firms. Second, the wide range of percentages resulting from the use of different measures confuses readers who are looking for simple benchmarks. To illustrate this second problem, the 48 firms studied reported total book value of assets at their last fiscal year-end prior to bankruptcy that were 38 percent higher than the total asset values they reported on their petitions. Even though the two measures of firm size perform about equally well in a regression, fees reported using the book value of assets will be about 28 percent lower than those reported using the petition value of assets. Building on Lubben, 44 we have attempted to determine what measures are best among the 12 suggested and recommend their use to subsequent researchers. We applied three criteria: plausibility of the measure, the closeness of the fit achieved in our model with each measure, and the availability of the data necessary to employ the measure. We rejected (4), the market value of public debt plus the book value of other debt plus the market value of equity, because of the difficulty of obtaining the necessary data. Historical bond trading prices are difficult to obtain for firms near bankruptcy and we could not determine from the Compustat data manual what data fields should be added to traded debt to reflect other debt. We rejected (10), distributions to creditors made during the case by stay lifting, asset abandonment, or payments under the plan, for use in the cases of large, public companies because we believe the files will contain inadequate valuation information with respect to collateral surrendered to secured creditors and the valuation and discounting of plan distributions is 42 James S. Ang, Jess H. Chua & John J. McConnell, The Administrative Costs of Corporate Bankruptcy: A Note, 37 J. Fin. 219, (1982) (reporting results). 43 Lawless, infra note 51, at (defining distributions ). 44 Lubben, supra note 4, at (arguing for the use of (7), the sum of the value of assets and liabilities reported on the petition).

14 124 Professional Fees in Bankruptcy Reorganization burdensome. 45 We do not dispute Lawless s contention that (10) may more reliably measure the size of small Chapter 11 debtors. 46 We rejected (5), the market value of debt plus the market value of equity, as implausible because it fails to account for bank and trade debt, and so would grossly underestimate the size of some firms. We rejected (9), the liquidated value of the firm at the end of the bankruptcy process, because it can be used only with the minority of cases that result in liquidation. We tested each of the eight remaining measures by using them, one at a time, as the measure of size in our professional fees regression model. Three measures, (6), the market value of equity, (11), the dollar amount of revenues, and (12), the number of employees, yielded a significantly worse fit than the others. The remaining five measures, (1), (2), (3), (7), and (8), performed about equally well. Of the five, we think that (2), the value of assets reported by the debtor on the bankruptcy petition, is the best measure and have employed it in our regressions. For the large majority of debtors, that value is readily available on Exhibit A of the bankruptcy petition on PACER. By contrast, (1), the book value of assets, measured at the fiscal year-end prior to the bankruptcy filing, is available only for public companies and (3), the book value of debt plus the market value of equity, requires stock data that was not available on Compustat for 18 of the 48 cases in this study (38 percent). 2. Scale Effect Professional fees increase with the size of the reorganizing firm. This increase is generally assumed to be subject to economies of scale. That is, professional fees are assumed to be a larger percentage of assets for small reorganizing firms than for large reorganizing firms. Betker concluded that fees increased with the log of assets This statement is based on the experience of Lynn M. LoPucki and William C. Whitford in a study of distributions in large, public company bankruptcies in the 1980s. They found that plans and disclosure statements contained inadequate information for valuing distributions to secured creditors. 46 Lawless, infra note 51, at 651 ( Because asset-based measures rely on self-reporting by the debtor, the distribution-based measures likely are more reliable. ). 47 Brian L. Betker, The Administrative Costs of Debt Restructurings: Some Recent Evidence, 26 Fin. Mgmt. 56, 59 (1997) ( for this sample of firms, direct costs increase with total assets but decline with the square of total assets ).

15 LoPucki and Doherty 125 To date, the search for this scale effect has been inconclusive. Warner found obvious economies of scale in a study of 11 railroad reorganizations. 48 Gilson found that direct costs exhibited economies of scale in a sample of out-of-court workouts. 49 Betker found economies of scale in a sample of outof-court workouts and Chapter 11 cases. 50 Lawless found weak economies of scale for professional fees in a study of small business bankruptcies. 51 But Weiss did not mention economies of scale in reporting a study of professional fees in large Chapter 11 cases. 52 After tests using several measures of size, Ferris and Lawless found economies of scale only for attorney fees standardized by nonsecured distributions in a sample of small Chapter 11 cases. 53 And Lubben found evidence of diseconomies of scale in a sample of large Chapter 11 cases. 54 We found economies of scale within our sample. As noted above in the discussion of Table 1, the regression coefficient for assets is positive but less than one, indicating that fees increase with assets at a declining 48 Warner, supra note 4, at 344 (graph showing obvious economies of scale). 49 Stuart C. Gilson, Troubled Debt Restructurings: An Empirical Study of Private Reorganzation of Firms in Default, 27 J. Fin. Econ. 315, 338 (1990) ( Direct costs of exchange offers in our sample also exhibit economies of scale. ). 50 Brian L. Betker, The Administrative Costs of Debt Restructurings: Some Recent Evidence, 26 Fin. Mgmt. 56, 59 (1997) ( for this sample of firms, direct costs increase with total assets but decline with the square of total assets ). 51 Robert M. Lawless, et al., A Glimpse at Professional Fees and Other Direct Costs in Small Firm Bankruptcies, 1994 U. Ill. L. Rev. 847, ( we found some evidence of a scale effect to professional fees in small business bankruptcies ). 52 Weiss, supra note 34 (not mentioning economies of scale). We corrected some of Weiss s data and tested it for a scale effect. See infra note 85. We found a scale effect using a log-log regression. The coefficient is (se = 0.066), which is significantly different from 1.00 (p < 0.05), but the difference is substantively very small. 53 Stephen P. Ferris & Robert M. Lawless, The Expenses of Financial Distress: The Direct Costs of Chapter 11, 61 U. Pitt. L. Rev. 629, 656 (2000). 54 Lubben, supra note 4, at ; id. at 535 ( The data is suggestive, however, of a possible trend in the opposite direction of economies of scale. Namely, larger assets may result in higher professional fees. ).

16 126 Professional Fees in Bankruptcy Reorganization Figure 1: The scale effect of assets on fees and expenses. $14,000,000 $12,000,000 Predicted fees and expenses (other variables at mean values) $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $ Assets (in millions of dollars) rate. 55 This relationship is illustrated in Figure 1, the values of which are derived from the regression equation with other variables constrained to their mean values. We expect a $1 billion firm to pay fees that are 29 percent higher than those paid by a $500 million firm, and a $1.5 billion firm to pay fees that are 16 percent higher than a $1 billion firm, all else held constant. Despite the conflicting results in prior studies, we think there can be little doubt that a scale effect exists. The studies to date have been small and the samples homogenous with respect to firm size. The scale effect becomes apparent on comparison across studies (Table 2). Putting aside the Altman and Weiss studies, the table shows that the larger the firm size studied, the lower the ratio of fees and expenses to firm size found. The Altman and Weiss anomalies are at least partly explained by the age of those studies. As we show in Part IV, controlling for the size of firms, fees and expenses have declined by 57 percent since the period of the Weiss study. 55 Regression models using the percentage of fees as the dependent variable strongly confirm the existence of a scaling effect in our data.

17 LoPucki and Doherty 127 Table 2: Cross-Study Comparison: Professional Fees in Chapter 11 Cases Fees and Expenses Did Study Study (Years of Cases Average Firm as a Percent of Find a Scale Studied) Size Firm Size n Effect? Lawless, et al. ( ) $695, % / 8.7% 57 No Ferris & Lawless ( ) $4,272, % / 16.5% 118 No Lubben (1994) $139,000, % 22 No Altman ( ) $302,285, % 18 No Weiss ( ) $561,534, % 31 No LoPucki & Doherty ( ) $881,600, % 48 Yes 1. Firm size is total assets. Percent of firm size is total fees and expenses divided by total assets. 2. First figures given for Lawless, et al. and Ferris & Lawless for Fees and Expenses as a Percent of Firm Size is for direct costs of bankruptcy and the second is for professional fees. Either figure might be considered comparable to figures for larger cases. 4. Ferris & Lawless found a scale effect only for attorneys fees standardized by nonsecured distributions. 5. We combined the cases in Altman s two groups, adjusted Altman s Bankruptcy Costs Direct and Value of Firm (t) for inflation, and then divided the former by the latter to obtain the percentage shown in this table. 6. Average firm sizes for Altman and Weiss are adjusted for inflation using the Consumer Price Index. 3. Professional Fee Burn Rates Earlier studies of professional fees have generally ignored the possibility of a relationship between the length and cost of Chapter 11 cases. 56 In doing so, the researchers have implicitly assumed that fees depend on the efforts necessary to resolve financial distress and that the time over which those efforts occur is not of great importance. Working with a sample of relatively small Canadian firms, Fisher and Martel recently concluded [t]here is no strong evidence of an effect of time in bankruptcy on administrative costs. 57 Many bankruptcy professionals and bankruptcy scholars see it differently. They believe that costs are largely a function of time in bankruptcy. 56 Brian L. Betker, The Administrative Costs of Debt Restructurings: Some Recent Evidence, 26 Fin. Mgmt. 63 (1997), concluded that time in distress is endogenously determined and likely to be a function of the same variables that I use to explain fees. We come to a different conclusion. We found in our data that assets, number of firms, and court location are relatively weak predictors of days in bankruptcy (R 2 = 0.25), and that the residuals of that model are very good predictors of fees and expenses. 57 Timothy C.G. Fisher & Jocelyn Martel, On Direct Bankruptcy Costs and the Firm s Bankruptcy Decision 6 (2001) (unpublished manuscript) (on file with Lynn M. LoPucki).

18 128 Professional Fees in Bankruptcy Reorganization Adopting a rocketry metaphor, they use the phrase burn rate to refer to the rate at which monthly fees are accruing. 58 This terminology suggests that the direct costs of Chapter 11 are principally a function of the length of the case. 59 Ferris and Lawless did find a positive, but weak, relationship between the length of the case and the amount of professional fees awarded. 60 Controlling for the size of the firm, we found that the length of time cases remained pending was positively correlated with the amount of fees and expenses awarded (Table 1). We estimate that doubling the time a case remains pending results in a 57 percent increase in fees. In other words, if two firms are identical in every respect (assets, number of firms, and location) except that one firm s case is pending for 180 days and the other s case is pending for 360 days, we would expect that the fees in the second case will be about 57 percent higher than the fees in the first case. This is illustrated in Figure 2. The implication of this finding on burn rates is similar to the scale effect above. As time pending increases, fees increase but at a declining rate. 4. Number of Professional Firms We found no prior research exploring the relationship between the number of professionals working in the case and the amounts of fees and expenses 58 Jonathan P. Friedland, Accounts Receivable and Retainer Management: Lessons from Pillowtex, 2002 ABI J. LEXIS 188 ( If a firm is going to draw fees from its retainer and not take in any new cash from a client in the 90 days preceding a filing, then the retainer needs to be estimated at an amount high enough to cover the total burn rate for that period. ). One reporter wrote: [I]n the first 13 months of the [Enron bankruptcy] professional fees have already hit $318 million...that s a burn rate of $24.5 million a month or $802,000 a day, 365 days a year in a case that could easily drag on for another year, or more, and continue to consume upward of $300 million in annual billings. Douglas Feiden, Cashing In Big-Time on Enron s Collapse: Gravy Train for Lawyers & Accountants, Daily News (New York), Feb. 2, 2003 at Id. See also Robert K. Rasmussen & Randall S. Thomas, Whither the Race? A Comment on the Effects of the Delawarization of Corporate Reorganizations, 54 Vand. L. Rev. 283, 295 (2001) (theorizing without data that fees may be correlated roughly with the length of the bankruptcy proceeding. The longer the proceeding, the greater the fees. ). 60 Ferris & Lawless, supra note 53, at 657 (for both attorney fees and total costs, there was a positive relationship between time in reorganization and bankruptcy costs; however, the relationship was weak, only approaching conventional levels of statistical significance).

19 LoPucki and Doherty 129 Figure 2: The burn rate over time of attorney fees and expenses. $14,000, $12,000, Predicted fees and expenses (other variables at mean values) $10,000, $8,000, $6,000, $4,000, $2,000, $ Days in bankruptcy incurred. 61 One might suppose that the amount of effort necessary to reorganize a firm is fixed. Dividing that effort among a larger number of professional firms would facilitate specialization, but would not increase substantially the total amount of work required or the total fees. Larger reorganizations might require performance of a larger number of tasks, but controlling for the size of the reorganizing firm should account for that effect. 62 Alternatively, one might suppose that for a firm of fixed size with a given set of problems, an increase in the number of professionals might cause a substantial increase in the total amount of fees and expenses incurred. The increase would derive from two sources: (1) the necessity for communication among the professionals and (2) adversarial interaction between the professionals. The second possibility is captured in the apocryphal story of a town that didn t have enough legal work to support one lawyer, but did have enough to support two. The implication was that in a 61 Warner mentions the existence of railroad reorganization cases with as many as 100 or 200 separate parties applying for fees. Warner, supra note 4, at That is, one might expect economies of scale with respect to the number, as well as the size, of the separate matters requiring attention.

20 130 Professional Fees in Bankruptcy Reorganization Figure 3: The cost of additional firms in bankruptcy cases. $14,000,000 $12,000,000 Predicted fees and expenses (other variables at mean values) $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $ Number of firms one-lawyer town matters generated little legal work because they went by default, but in a two-lawyer town those same matters could be litigated. Controlling for firm size, duration of the case, and court location, we found a significant correlation between the number of professional firms employed in the case and the amounts of professional fees and expenses incurred. The larger the number of firms, the greater the professional fees and expenses. Every new firm results in an increase in fees and expenses, on average, of 6.5 percent (Table 1). Since this increase is multiplicative (each 6.5 percent is an increase over previous increases), adding firms increases the cost of a bankruptcy exponentially. This is illustrated in Figure 3. The percentage difference in fees between each data point in the graph is the same, but the multiplying effect of adding firms leads to a line that slopes up at an increasing rate. 5. Court Competition The filing of large, public company reorganizations in Delaware is a recent phenomenon of sudden onset. During the decade of the 1980s, the Delaware Bankruptcy Court attracted not a single large, public company bankruptcy

21 LoPucki and Doherty 131 from outside the state. In 1990, it attracted two. By 1996, the Delaware Bankruptcy Court was attracting 87 percent of all large, public company bankruptcies filed in the United States. LoPucki and Whitford argued that a decade before Delaware came to dominance, the New York Bankruptcy Court attracted cases by awarding relatively high attorney fees. 63 Many have assumed that generous fee awards were also part of Delaware s attraction. On the other hand, Rasmussen and Thomas have defended the Delaware Bankruptcy Court with the supposition that because it processes cases more quickly, Delaware s fee awards must be lower. 64 Controlling for firm size, length of the proceeding, and number of professional firms in the case, we found that Delaware awarded fees that were significantly higher 32 percent higher than those awarded in other courts. This finding in itself does not contradict Rasmussen and Thomas s assumption that the costs of reorganizing a firm in Delaware are lower than the costs of reorganizing a like firm elsewhere. Rasmussen and Thomas s assertions related to the total of direct and indirect costs. Even with respect to direct costs, researchers seeking to compare fees for reorganization of a given firm across courts should not control for time in Chapter 11. So to investigate the portion of Rasmussen and Thomas s assumption that related to direct costs, we compared fees and expenses in Delaware with those in other cities controlling only for firm size. We found that Delaware fees were very slightly higher than fees in other courts, but the difference was not statistically significant. 65 We conclude that our data regarding direct costs 63 Lynn M. LoPucki & William C. Whitford, Venue Choice and Forum Shopping in the Bankruptcy Reorganization of Large, Publicly Held Companies, 11 Wis. L. Rev , (1991). 64 Rasmussen & Thomas, supra note 59, at 295 (asserting without data that fees may be correlated roughly with the length of the bankruptcy proceeding...[t]he longer the proceeding, the greater the fees and proceeding to a hypothetical in which Delaware s total of direct and indirect costs are assumed to be lower than fees in other courts). 65 We controlled for firm size by generating unstandardized residuals, which are what remain after regressing the natural log of assets (our independent variable) on the natural log of fees and expenses (our dependent variable). We then used ANOVA to see if there were any significant differences between cases filed in Delaware and in other courts (categorized as New York and Other ) in the residuals. There were not (n = 48, F = 0.024, p = 0.976).